Friedman is also famous for a second theory, this one containing
much more merit. It's called the natural rate of unemployment.
(1) To understand it, we should review the early Keynesian goal
of reaching "full employment."

"Full employment" does not mean 100 percent employment.
For various reasons, the unemployment rate cannot be reduced to
zero, if only because people are always being fired, laid off
or moving between jobs. But even granting that unemployment can
never be completely eliminated, it still might be possible to
ensure that anyone searching for a job can find one reasonably
quickly. Economists call this happy state of affairs "full
employment."

How can it be reached? Early Keynesians believed that they could
achieve it by expanding the money supply. Of course they could
not overdo it. Keynes himself knew of this danger when he wrote
Tract on Monetary Reform in 1923. The central bank could
expand the money supply right up to the point where full employment
was reached; after that, any monetary expansion would result in
inflation. The question was how much to expand.

An apparent answer emerged in 1959, when British economist A.W.
Phillips discovered a relationship between wages and unemployment
in British historical statistics. When unemployment was high,
wages had fallen; when unemployment was low, wages had risen.
A look at American statistics revealed the same tradeoff. Since
wage changes are indicators of inflation, this discovery actually
showed that a tradeoff existed between inflation and unemployment.
Accepting more of one meant less of the other. When graphed, this
tradeoff produced a nice, neat curve, which became known as the
"Phillips Curve."

This discovery helped policy-makers determine how much to expand
the money supply. Previously, no one really knew what constituted
"full employment." Now they could make a judgment call.
The curve showed them how far they could expand the economy without
letting the cost of inflation outweigh the cost of unemployment.
This seemed to be 3 or 4 percent inflation in return for 4 percent
unemployment.

Over the next few decades, many public figures would call for
the unemployment rate to be reduced to 4 percent; the 1978 Humphrey-Hawkins
Act went so far as to put it into law. But economic events and
advances in theory would overtake them. In 1968, Milton Friedman
challenged the whole concept of the Phillips Curve, and his efforts
would secure him lasting fame and the 1976 Nobel Prize. His argument
went something like this:

Imagine an economy where the cost of everything doubles. You have
to pay twice as much for your groceries, but you don't mind, because
your paycheck is also twice as large. Economists call this the
neutrality of money. If inflation worked this way, then
it would be harmless. Of course, inflation does have other negative
consequences, but they are minor compared to the terrible costs
of widespread unemployment. (2) Hence the Keynesian policy of
accepting high inflation in exchange for low unemployment.

But Friedman had a question: why is it that when the Fed expands
the money supply by, say, 5 percent, all prices and wages everywhere
do not go up by 5 percent as well? Why wouldn't the neutrality
of money make this expansion meaningless? Friedman argued that
it was because the public didn't know that they should raise their
prices by 5 percent. That's because they were unaware of the expansion,
or what it meant, or how large it was if they did. When the extra
money was pumped into the economy, therefore, it was unwittingly
translated into more economic activity, not higher prices.

However, if businessmen knew that a 5 percent increase
was coming, it would be in their best interest just to raise their
prices 5 percent. That way, they would make the same increased
profits without having to work for them. Or, seen another way,
if businessmen knew that inflation was going to be 5 percent every
year, they would simply build those expectations into their normal
price increases. But if everyone did this, then the Fed's monetary
increases would become meaningless -- instead of resulting in
more jobs, they would just create higher inflation. In other words,
the neutrality of money would take over. To maintain the job creation
effect, the Fed would have to surprise businessmen with a 10 percent
increase the next year. But businessmen would eventually come
to expect that as well -- requiring a 15 percent increase the
next year, and so on, all the way to hyperinflation.

Friedman and others argued that as businessmen became wiser to
the Fed's actions, the Fed would no longer have a tool to fight
unemployment. And without this tool, unemployment would eventually
start climbing as well, along with inflation, forming a twin monster
that Paul Samuelson dubbed "stagflation." And indeed,
from the late 60s all the way through the 70s, this is precisely
what happened. Stagflation peaked on Jimmy Carter's watch, costing
him his reelection for the presidency.

Friedman showed that monetary policy could not be used to achieve
full employment. Unfortunately, inflation starts accelerating before
full employment is reached. The best a nation can do is settle for
the lowest level of unemployment that will not begin accelerating
inflation. Friedman called this point the
"natural rate of unemployment,".

Some controversy exists over what the natural rate is, because it depends
partly on what markets expect inflation will be. But in the U.S. today, economists
estimate it to be slightly less than 6 percent. Friedman is said
to regret the term "natural rate of unemployment," since
it implies that a certain amount of unemployment is acceptable.
Therefore, most economists prefer to use the euphemism "NAIRU,"
which stands for Non-Accelerating Inflation Rate of Unemployment.

The natural rate of unemployment does not mean that Keynesianism
is still not a useful tool for smoothing out the business cycle.
Six percent is merely an average; in reality, unemployment can
deviate substantially from 6 percent. Keynesian policies are therefore
useful for stabilizing unemployment at this figure.

As one might expect, the natural rate of unemployment is not without
controversy. Although most top-level economists -- on both the
left and the right -- accept its validity, there are many economists
who believe the NAIRU doesn't even exist. A few important dissidents
include John Kenneth Galbraith and Robert Eisner, both past Presidents
of the American Economics Association. A much more widespread
controversy, though, is where to peg the natural rate. Nearly
all economists agree that it is not a fixed figure, but that it
can float. Galbraith, tongue firmly in cheek, writes:

"That 5.5 to 6 percent consensus is easily explained: it's
where the actual unemployment rate is. And that is usually been
true: the estimated NAIRU tracks actual unemployment. When unemployment
goes up, conservative economists raise their NAIRU. When it falls,
they predict inflation, and if inflation doesn't happen they cut
their estimated NAIRU. There is a long and not-very-reputable
literature of such estimates -- you can look it up. In fact, this
little corner of the professional record is embarrassing."
(3)

And this debate has a political cast as well: conservatives like
a high NAIRU, liberals, a low one. When it's high, interest on
bonds pay more, thanks to low inflation. Conservatives like that
because most bond-holders are wealthy. Furthermore, when the unemployment
rate is high, wages tend to fall, in accordance with the laws
of supply and demand on the labor market. Exploiting labor, as
they say, is profitable business. The current Fed chairman, Alan
Greenspan, is a died-in-the-wool conservative and a self-described
"inflation hawk," meaning that he is committed to a
high NAIRU. Conversely, liberals prefer a low NAIRU because it
raises workers' wages.

Friedman's discovery of the natural rate took the wind out of
the Keynesians' sails concerning one of their most important goals.
It raised the prestige of the Chicago School of Economics and
turned it into a leading advocate of unfettered capitalism. But
in the end he did not accomplish what he had set out to do: replace
Keynesianism.

2. Inflation is harmful because it transfers wealth from loaners
to borrowers, makes financial planning difficult, alters investment
decisions, erodes fixed incomes, devalues savings, leads to more
barter transactions, and costs individuals more time and effort
by keeping more of their money in interest-accruing bank accounts
rather than on hand.